Assessing Risk

Credit Risk

You should assess the creditworthiness of a zero coupon municipal bond the same way you would any municipal security. Doing so is particularly important for zero coupon bonds since all your principal investment returns are paid at maturity. For municipal bonds, credit risk is determined by the financial and operating stability of the state or local government entity that issued the bond or the entity that is obligated to pay the principal of and interest on the bonds.

Virtually all new issues of municipal securities are originally offered by means of disclosure documents (called official statements or offering circulars) that describe in detail the financial condition of the issuer or the entity responsible for making payments on the bonds. From these disclosure documents, which are available through the Municipal Securities Rulemaking Board's Electronic Municipal Market Access portal at http://emma.msrb.org, investors can determine the risks involved in the investment. In assessing the relative quality of zero coupon municipal bonds, investors may consider the ratings provided by one or more of the three major rating agencies, which have established the following classifications:

Generally, bonds that are rated at least BBB or Baa by Standard & Poor’s and Fitch Ratings or Moody’s, respectively, are considered to be “investment grade,” or suitable for preservation of invested capital. Bonds with lower ratings indicate a higher degree of risk.

The rating agencies grade bonds according to their investment qualities but do not intend the rating to be the sole basis for an investment decision. The ratings cannot, for example, forecast market trends. Before purchasing any bonds, particularly those with lower ratings, talk with your investment advisor to make sure they are suited for you.

Market Risk

As with all fixed-income securities, the yields or interest rates on zero coupon municipal bonds fluctuate, usually in step with general market rates. While the interest on a bond is fixed by the price you paid, newer bond issues may be offered at higher or lower rates depending on prevailing interest rates when they are issued.

Like other bonds, the values of zero coupon municipal bonds move inversely to the movement of interest rates: bond values will increase as interest rates decline, and bond values will decrease as interest rates increase. As a result, zero coupon municipal bonds that were purchased when interest rates were higher and sold in the secondary market when interest rates are lower will generate capital gains. Conversely, investors who sell their bonds during periods of rising interest rates will incur capital losses.

Zero coupon bonds are more sensitive to interest rate swings than bonds which pay interest semiannually because all the interest payments of zero coupon bonds are accumulated and paid at maturity. A coupon bond which pays interest semiannually loses its volatility as it draws closer to maturity because its true value to investors—interest—slowly dwindles as the number of interest payments left declines. The longer the maturity of a bond, the greater the volatility.

Call Provisions

Many municipal bond issues allow the issuer to call (or redeem) all or a portion of the bonds at a premium or at par before maturity. When investors purchase bonds, dealers will quote the yield to call date if it is less than the yield to maturity. Therefore, an investor can know what the return on the bond will be if the issuer exercises its right to call the bonds.

Typically, zero coupon municipal bonds containing call provisions provide that the bonds may be called at the option of the issuer on a specific date at a price or premium based on the accreted value of the security that was established at the time of issuance (known as the original accretion rate).

Before purchasing state and local bonds which are subject to special redemption provisions, as well as bonds that contain sinking funds, you should pay careful attention to the call provisions. In addition, investors purchasing bonds at a premium in the new issue or secondary market should use care when paying prices in excess of an issue’s original accretion rate because a call may result in a lower than expected yield or even a loss.

All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.